Federal Reserve Chairman Alan Greenspan’s testimony to Congress last week gave traders of fixed income paper an excuse to dump Bonds (see chart), which they did with near reckless abandon, driving up yields as they locked in profits. Their actions led us to consider what future impact bond yields might have on both the economy and equity markets.

In our opinion, government treasuries with attractive yield could derail the equity rally; A 5+% riskless yield in the 30-year might pull flows away from equities and money market accounts. It might also endanger the economic recovery – specifically, new homes sales, existing homes sales, and re-financings. As this has been one of the few bright spots in the economy, it bears close monitoring over the next year.

What might cause a sustainable rise in interest rates? We identify 3 likely factors: 1) The re-issuance of the 30 year bond by the Treasury Department; 2) Strengthening of the economic recovery; 3) Technical Break down of Treasuries.

The Treasury Department’s decision to eliminate the 30-year bond in Fall 2001 caused an acceleration of the bond rally. The benefit of hindsight reveals Treasury’s presumption of continued budget surpluses as hopelessly optimistic. As we discussed in March, investors should expect Federal Budget deficits for at least the next 5 years, possibly longer. We believe patient government fixed income buyers will eventually see more attractive coupons.

The more curious hazard is the improving economy itself. To date, economic expansion has been anemic. If the jobless recovery maintains its present lackluster pace, the economy may sputter and fail. Employment numbers have been going south instead of improving. A recovery that fails to generate new jobs isn’t very much of a recovery at all.

On the other hand, if the pace picks up too rapidly, the Fed may have to resume its role of inflation fighter. If the Fed is forced to increase interest rates, it will hurt homes sales, refis and consumer spending. Thus, a too rapidly improving economy sows the seeds of its own destruction.

That’s the bind the Fed now finds itself in: The threat of deflation is fading, with inflation looking if not likely, than certainly more possible than was thought a mere two months ago. Rising rates in a slow growth, jobless recovery does not lend itself to a positive legacy for the Chairman. Equity investors must also be diligent rate watchers, as a continued rise could put their rally in jeopardy.

Chart of the Week:
Treasury yields have bounced off of their lows recently. After a 3 year Bull Market in government fixed income paper, with deflation fears fading, Traders have been locking in profits. If Bond sales continue, yield instruments may once again find a new round of buyers.

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About Barry Ritholtz

Ritholtz has been observing capital markets with a critical eye for 20 years. With a background in math & sciences and a law school degree, he is not your typical Wall St. persona. He left Law for Finance, working as a trader, researcher and strategist before graduating to asset managementRead More...

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"The largest Asian central banks have gone on record that they are curbing their purchases of US debt. And they are also diversifying their huge reserves, steadily moving away from the dollar. The risks have simply become too many and too serious." -W. Joseph StroupeEditor, Global Events

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